Revenue Recognition Explained (2024)

Earning cash as a business is exciting. However, let’s put the brakes on for a second beforeyou immediately recognise that revenue. Has your business actually “earned” that revenue?

Revenue recognition has been a hot topic for the past several years thanks to the dualrelease in 2014 of the International Financial Reporting Standard (IFRS) 15 ‘Revenue fromContracts with Customers’ and the Accounting Standards Codification (ASC) 606 in the UnitedStates.

Released by the Financial Accounting Standards Board (FASB) as a part of Generally AcceptedAccounting Principles (GAAP) in the U.S., ASC 606 standardised how companies shouldrecognise revenue, particularly in incidents when the nature, certainty and timing ofrevenue might be complicated. As part of a broad effort to converge revenue standards acrossmultiple regions including the U.S., the International Accounting Standards Board (IASB)released similar guidance designed to work in harmony with the ASC 606 standard as a part ofthe International Financial Reporting Standards (IFRS) framework to dictate when revenue canbe considered earned and the financial statement accurately updated. This was encapsulatedin the IFRS 15 standard, which has since been adopted by many countries around the world.Asia Pacific (APAC) businesses looking to learn more about IFRS 15 can find more informationon the IFRS Standards Navigator or from your local accounting standard board.

Curious about when your company should recognise its revenue? Read on for the latest andgreatest in our comprehensive revenue recognition guide.

What Is Revenue Recognition?

Revenue recognition is an accounting principle that asserts that revenue must be recognisedas it is earned. So, the question becomes: when is revenue considered “earned” by a company?Revenue is generally recognised after a critical event occurs, like the product beingdelivered to the customer.

Key Takeaways

• Revenue recognition standards can vary based on a company’s accounting method,geographical location, whether they are a public or private entity and other factors.
• The revenue recognition principle, a key feature of accrual-basis accounting, dictatesthat companies recognise revenue as it is earned, not when they receive payment.
• Accurate revenue recognition is essential because it directly affects the integrity andconsistency of a company’s financial reporting.
• In order to standardise processes around revenue recognition, the FASB released ASC 606,which provides a five-step framework for recognising revenue.
• IASB subsequently collaborated with the FASB and issued the internationally recognisedIFRS 15, Revenue from Contracts with Customers standard. This adopts the basic five-stepframework laid out in the ASC 606 model.

Revenue Recognition Explained

In essence, revenue recognition looks to answer when a business has actually earned itsmoney. Typically, revenue is recognised after the performance obligations are consideredfulfilled, and the dollar amount is easily measurable to the company. A performanceobligation is the promise to provide a “distinct” good or service to a customer. On thesurface, it may seem simple, but a performance obligation being considered fulfilled canvary based on a variety of factors.

The revenue recognition principle is a key component of accrual-basis accounting. Thisaccounting method recognises the revenue once it is considered earned, unlike thealternative cash-basis accounting, which recognises revenue at the time cash is received. Inthe case of cash-basisaccounting, the revenue recognition principle is not applicable.

Essentially, the revenue recognition principle means that companies’ revenues are recognisedwhen the service or product is considered delivered to the customer — not when the cash isreceived. Determining what constitutes a transaction can require more time and analysis thanone might expect. In order to accurately recognise revenue, companies must pay attention tothe five steps laid out in both the ASC 606 model and the IFRS 15 standard, and ensure theyare interpreting them correctly. More on the Five-Step Model later.

Why Is Revenue Recognition Important?

Proper revenue recognition is imperative because it relates directly to the integrity of acompany’s financial reporting. The intent of the guidance around revenue recognition is tostandardise the revenue policies used by companies. This standardisation allows externalentities — like analysts and investors — to easily compare the income statements ofdifferent companies in the same industry. Because revenue is one of the most importantmeasures used by investors to assess a company’s performance, it is crucial that financialstatements be consistent and credible.

Revenue Recognition Examples

To better understand revenue recognition, let’s walk through two examples of companies withdifferent business models.

• Example: Subscription Service

  The popularisation of the subscription model presented some revenue recognitionchallenges. Instead of a one-time transaction, subscription models presented avariety of ways to pay – annual, quarterly, monthly, etc. With different standardsexisting dependent on industry, the IFRS decided to standardise the process acrossvarious regions by adopting the five-step model for recognising revenue that waspioneered by FASB with the introduction of the ASC 606 model. The five steps laidout in the model are used to identify specific contractual obligations with theirassociated pricing and to define how revenue will be recognised.For example, a coffee subscription company charges $25 a month to send a sampling ofground coffees to its subscribers. It also charges a one-time $50 startup fee forthe process of learning more about the consumer, creating a curated selection ofcoffees and sending a pour-over coffee maker as a part of the subscription program.Once the initial process is complete (i.e., the consumer has completed thequestionnaire, the company has created a curated plan and the pour-over coffee makerhas been delivered), that $50 can be recognised. The recurring fee, however, ischarged on the first of each month even though the coffee itself is not delivereduntil mid-month. The company cannot recognise that $25 recurring payment when theyreceive it, as the business has not technically earned it yet.

  Because the startup process has been completed, that revenue can be recognised asearned. However, since the monthly service has not yet been delivered, theaccounting ledger must reflect that. Thus, the revenue is deferred. At the end ofthe month, when the business has delivered both the startup process and the monthlyservice, the ledger can be updated to reflect the newly recognised revenue.

  See Also

  ASC 606 e IFRS 15: Explicación del reconocimiento de ingresos | StripeReconciling Revenue Recognition Principles in the Software IndustryWhat is IFRS 15?IFRS 15 — Revenue from Contracts with Customers

  Let’s look at another relevant situation here. A current consumer decides to opt intothe annual coffee subscription plan, meaning that they pay for 12 months of theservice at a discounted upfront cost of $264 ($22/month). The coffee company cannotrecognise that $264 upfront, as it has not delivered the service/product. Instead,the business will recognise the $22 each month after the consumer receives theircoffee sampler.

• Example: Independent Contractors

  Independent contractors also face a perplexing accounting situation, because whenthey are paid often varies.As an example, let’s say an independent digital design agency is hired by a startup.The startup agrees to pay the contractor for three performance obligations: websitecreation, logo design and digital ads ($12,000, $4,500 and $3,500, respectively).The agency will be paid after each product is delivered.The digital design company’s ledger, because it has not earned the revenue yet,would first display as such:

  The agency completes and delivers the website in the first month, leading to a ledgerupdate – even if they have not been technically paid by the client yet. As soon asit’s delivered, the performance obligation is considered fulfilled.

  In the following month, it finishes and delivers the logo designs.

  In the third month, the digital ads are done and delivered, so the agency hasfulfilled its performance obligations. Thus, the remaining revenue can berecognised. Again, this can be recognised even if the startup hasn’t technicallypaid them yet. The performance obligations have been fulfilled, meaning the revenuecan be recognised.

Conditions for Revenue Recognition

Conditions for revenue recognition differ based on a company’s geography, business model,whether it is a public or private entity, its bank, investors and numerous other factors.

However, for companies operating in the APAC region, the standards set by the IFRS providethe overarching framework and guidance when it comes to recognising revenue. Some 144countries have mandated the IFRS standards, with the relevant accounting practices in eachapplicable region a legal requirement for financial institutions and public companies.

Many companies in regions where the IFRS standards are not mandated voluntarily follow IFRS guidelines, even if the predominant model may be dictated by adifferent mandated standard. In the U.S., for example, public companies are required tofollow GAAP standards, while in Japan, the J-GAAP standard is used. This means that globalcompanies with entities in APAC and other regions where IFRS standards are mandated mayreport back to parent companies that typically employ the GAAP standard

IFRS Reporting Standards Criteria

According to IFRS criteria, the following conditions must be satisfied for revenue to berecognised:

1. Risk and rewards have been transferred from seller to the buyer.
2. Seller has no control over goods sold.
3. The collection of payment from goods or services is reasonably assured.
4. Amount of revenue can be reasonably measured.
5. Cost of revenue can be reasonably measured.

These criteria fall under three buckets that the IFRS lists as necessary for a contract toexist: performance, collectability and measurability. The first two criteria listed areclassified under “performance.” Performance is achieved when the seller has done most or allof what it is supposed to do to be entitled to payment. The third is a “collectability”condition, which means that the seller must have a reasonable expectation of being paid. Thelast two are considered “measurability” conditions because of the matching principle: theseller must be able to match expenses to the revenues it helped earn. Therefore, the amountof revenues and expenses should both be reasonably measurable.

Revenue Recognition Requirements

Organisations in many parts of the world, including much of the APAC region, require IFRS 15for domestic public companies. It is also a popular accounting standard for many privatecompanies in the region.

IFRS 15, which was issued in 2014 and made effective for annual reporting periods beginningon or after 1 January 2018, applies to all contracts with customers, although there are someexceptions.

For example, the standard does not cover financial instruments and other contractual rightsor obligations within the scope of IFRS 9 ‘Financial Instruments’ or IFRS 10 ‘ConsolidatedFinancial Statements’.

Moreover, in some circ*mstances, a contract with a customer may be partially within the scopeof IFRS 15 and partially within the scope of another standard. You can find more about theseexceptions on the IFRS Standards Navigator or from your local accounting standard board.

Five-Step Model for Recognising Revenue – IFRS 15

While guidance already existed for contracts, the rules varied and were somewhat subjective.In response, the International Accounting Standards Board (IASB) introduced IFRS 15 in May2014 to provide a uniform comprehensive revenue recognition model for all contracts withcustomers. This was in line with FASB’s ASC 606 revenue standard in the U.S., which was alsoissued in May 2014. The updates aimed to establish some guidance around contracts, as wellas some clarity and standardisation around the entire revenue recognition process byreplacing different industry and transaction-specific guidelines with a five-step framework:

1. Identify Contract With Customer:

   In order to complete this step, the parties must fulfill several criteria. Allparties must first approve of the contract and be committed to fulfilling theirobligations. The contract will outline each party’s rights as well as the paymentterms regarding the goods or services to be transferred. It also must have“commercial substance.” This means that both sides expect the future cash flows of abusiness will change as a result of the transaction. Lastly, collectability must beprobable. This means that payment is likely to be received (i.e., the customer’scredit risk should be evaluated at contract inception).

2. Identify Performance Obligation(s):

   In this step, an entity must identify all distinct performance obligations. Aperformance obligation is a promise in a contract to transfer a good or service tothe customer. There are two criteria for a good or service to be considereddistinct, and both of those criteria must be met.

   1. A good or service is capable of being distinct if the customer can benefit fromit on its own or with other resources that are readily available.
   2. A good or service must also be separately identifiable from other promises inthe contract to be considered distinct — commonly referred to as being “distinctin the context of the contract.”

3. Determine Transaction Price:

   This part of the process entails determining the amount of consideration the entityexpects to be entitled to, in exchange for transferring promised goods or servicesto a customer (i.e. the transaction price). In many cases, this step isstraightforward, as the seller will receive a fixed amount of cash simultaneouslywith the transferred goods or services. However, effects from several factors cancomplicate the determination:

   1. Variable considerations: When there is uncertainty around the amountof consideration, like in instances of discounts, rebates, refunds, credits,incentives and similar items. If the consideration is variable, an entity canestimate the amount of consideration to which it will be entitled in exchangefor the promised goods or services.
   2. Constraining estimates of variable consideration: After estimatingvariable consideration, entities must assess the likelihood and magnitude of thepotential revenue reversal (due to factors like market volatility).
   3. The existence of a significant financing component: When there is morethan a year between receiving consideration and transferring goods or services,a contract may have a significant financing component. A financing component inthe transaction price considers the time value of money.
   4. Non-cash considerations: When a consumer pays in the form of goods,services, stock or other non-cash consideration.
   5. Considerations payable to the customer: Instances where a company mustalso make a payment to a consumer like slotting fees, cooperative advertising,buydowns, price protection, coupons and rebates.

4. Allocate Transaction to Performance Obligation(s):

   If a contract has more than one performance obligation, a company will need toallocate the transaction price to each separate performance obligation based on itsrelative standalone selling price.

5. Recognise Revenue as Performance Obligation(s) is Satisfied:

   The final step is to recognise revenue when or as the performance obligations in thecontract are satisfied.

   1. Transfer of Control: When a customer obtains control over the asset,it is considered transferred and the company’s performance obligation isconsidered satisfied. The company can then recognise that revenue.

   2. Performance Obligations Satisfied Over Time: As a company transferscontrol of a good or service over time, it satisfies the performanceobligation and can recognise revenue over time if one of the followingcriteria is met:

      1. The customer receives and consumes the benefits provided by the entity’sperformance as the entity performs.
      2. The entity’s performance creates or enhances an asset (for example, workin progress) that the customer controls as the asset is created orenhanced.
      3. The entity’s performance does not create an asset with an alternativeuse to the entity (see IFRS 15:35), and the entity has an enforceableright to payment for performance completed to date.

      An example of performance obligations being satisfied over time would be aroutine or recurring cleaning service. The customer will receive the benefitof the vendor’s cleaning service as it’s being performed simultaneously.

   3. Performance Obligations Satisfied at a Point in Time: If aperformance obligation is not satisfied over time, the performanceobligation is satisfied at a point in time. To determine the point in timeat which a customer obtains control of a promised asset and the companysatisfies a performance obligation, it should consider guidance on controland the following indicators of the transfer of control:

      1. The company has a present right to payment for the asset.
      2. The customer has legal title to the asset.
      3. The company has transferred physical possession of the asset.
      4. The customer has the significant risks and rewards of ownership of theasset.
      5. The customer has accepted the asset.

      For example, an online ecommerce store sends a shirt to a customer. Thatcustomer has 30 days after receipt to return the shirt if needed. Thecompany will consider the performance obligation fulfilled and the 30 dayshas passed.

   4. Measuring Progress Toward Complete Satisfaction of a PerformanceObligation: For each performance obligation satisfied over time, acompany should recognise revenue over time by measuring the progress towardcomplete satisfaction of that performance obligation. Methods for measuringprogress include the following:

      1. Output Method: Outputs are goods or services finished andtransferred to the customer. A company first estimates the amount ofoutputs needed to satisfy the contract. The entity then tracks theprogress toward completion of the contract by measuring outputs todate relative to total estimated outputs needed to satisfy theperformance obligation. Number of products produced or servicesdelivered are both examples of output measures.

      2. Input Method: Inputs are measured by the amount of effortthat has been put into satisfying a contract. The input method isimplemented by first estimating the total inputs required to satisfya performance obligation. The company then compares efforts to datewith the estimated total needed to satisfy the performanceobligation. For example, money, time and materials utilised are allinput measures.

The revenue standard for public companies was initially scheduled to become effective forannual reporting periods beginning on or after 1 January 2017. In September 2015, IFRSdeferred the effective date of IFRS 15, making the standard effective for annual reportingperiods beginning on or after 1 January 2018, with earlier application permitted, dependingon an entity’s financial reporting year. The standard applies to public, private andnon-profit entities. Check with your local accounting standard board to find out more abouthow different types of entities are required to adhere to the standard.

IFRS Revenue Recognition Principles

Given the broad adoption of IFRS throughout APAC, IFRS 15 plays a big role in dictating howorganisations in the region recognise revenue.

In the words of the IFRS Foundation, the core principle of IFRS 15 is that, “an entityrecognises revenue to depict the transfer of promised goods or services to customers in anamount that reflects the consideration to which the entity expects to be entitled inexchange for those goods or services.”

An entity recognises revenue in accordance with that core principle by applying the fivesteps outlined earlier.

This principle ensures that companies in compliance with IFRS 15 recognise their revenue whenthe service or product is delivered to the customer — not when the cash is received.

Previous revenue recognition guidance in various regions around the world was immenselycomplicated. There were numerous and inconsistent requirements on how to recognise revenue,differing greatly across industries and geographies. This led the IASB, as the internationalfinancial standards body, to issue IFRS 15, and FASB, in the U.S., to release theaforementioned update to ASC 606. Together, the new standards replaced hundreds of differentindustry and transaction-specific guidelines with a basic, five-step framework. The intentis to provide more information around how to handle revenue recognition in contractualsituations and offer an industry-neutral framework for improved comparability of financialstatements.

The release of the IFRS 15 and ASC 606 standards has essentially achieved convergence between the U.S. GAAP and IFRS, with only someminor differences.

For companies of all sizes, both public and private, revenue recognition is an importantconcept to understand fully. It is critical for businesses to look strategically at revenuerecognition policies to ensure they are compliant now and are conducive to the company’sfuture financing, filing and expansion goals. To that end, advanced financial managementsoftware will help you schedule, calculate and present revenue on your financial statementsaccurately, automating revenue forecasting, allocation, recognition, reclassification, andauditing through a rule-based event handling framework — whether your business conductssales transactions that consist of products or services, or both, and, whether thesetransactions occur at a single point in time or across different milestones.

Revenue Recognition FAQs

Do small businesses need to understand revenue recognition?

Small businesses do need to understand revenue recognition and its associated principles.From a financing perspective, financial statements adhering to the respective standardsacross APAC that incorporate IFRS 15 are commonly understood by lenders and investors,providing credibility to the financial reporting and the company as a whole. Thus, even inthose instances where it may not be mandatory, having -revenue recognition practices andfinancial statements that comply with your region’s specific accounting standards can openup more financing options and sources, often at a lower cost — making it easier to build andexpand a business. For companies that are considering going public eventually, alreadyadhering to the respective standards that apply in your region can help ease the transition.When a private company goes public, the company will have a different ownership and capitalstructure, investors with varying investment strategies, generally more accounting resourcesand limited investor access to management. Therefore, the company must immediately meet theregulatory requirements in the market in which it is filing.

How does revenue recognition help my business?

Revenue recognition isn’t just for compliance purposes — it is of benefit for companies torecognise revenue in a consistent manner, as well. Internally, companies can review andcompare their current financials with past ones without qualm, knowing that their revenuerecognition policies have remained consistent. Following the standards for revenuerecognition also allows for easy external comparison so businesses can quickly and easilygauge how they are performing relative to their competitors.